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Morningstar | Telstra Joins the Fight Club

Telstra's fiscal 2018 earnings release was uneventful, with the 5% decline in EBITDA to AUD 10.1 billion in line with our expectations and fiscal 2019 guidance reiterated at an EBITDA range of AUD 8.8 to 9.5 billion (up AUD 100 million but purely due to accounting changes). Then again, the narrow-moat-rated group could do with a little uneventfulness, having just endured a torrid stretch marred by rising competitive intensity, negative earnings revisions, and heavy restructuring pains, both at the staff and product level.

While still early days, there are some encouraging signs of Telstra's fightback plans bearing fruit. The 174,000 post-paid mobile subscriber addition in the June half was solid, with the momentum especially impressive in the June quarter (114,000 versus 60,000 in the March quarter). The 135,000 increase in fixed-line retail-bundle broadband customers during the six months was also notable. While these increases are coming at a cost--mobile EBITDA margin down 290 basis points to 39.9%, fixed data margins almost halving to 16.0%--it is critical Telstra shore up its customer base and positions itself to monetise them in the upcoming 5G era.

The cost-out story is also taking shape, with AUD 480 million in core fixed expenses cut during fiscal 2018, or AUD 700 million in cumulative amount over the past two years. The importance of continuing progress on this front, towards the AUD 2.5 billion cost-reduction target by fiscal 2022 cannot be underestimated, not only to offset competitive pressures and NBN's margin-crunching impact but for the sake of management credibility. Indeed, this "self-help" measure is a key plank behind our unchanged Telstra fair value estimate of AUD 4.40 per share, while the solid balance sheet arms Telstra with the necessary financial resources to see through the "fightback" and transformation journey--one that will no doubt be punctuated with periodic hiccups and challenges.

This is the reason we are comfortable with management's intention to keep radio silence on the dividend front from fiscal 2019. Amid intensifying competition in the rapidly-moving telecom industry, we believe the days of Telstra handicapping itself by committing to an onerous dividend commitment are over. As such, we maintain our forecast that fiscal 2019 DPS will be AUD 0.15, down from AUD 0.22 in fiscal 2018, and equating to a payout ratio of 69%.

Telstra's fiscal 2018 net profit after tax, or NPAT, fell 8% to AUD 3.6 billion, with EPS coming in at AUD 0.30, down from AUD 0.33 a year ago. The final DPS of AUD 0.11 was in line with our expectations and brings the total DPS for the year to AUD 0.22, fully franked.

Divisionally, mobile EBITDA fell 6% to AUD 4.0 billion, with increasing competitive intensity reflected in the 3% to 4% decline in average revenue per user, or ARPU, and the abovementioned fall in margin. Nevertheless, growth in the customer base is encouraging. An additional 300,000 post-paid subscribers during the year more than offset the loss of 100,000 prepaid customers.

Fixed EBITDA (voice and data combined) declined 42% to AUD 1.3 billion, driven by the loss of 470,000 fixed voice customers. This loss saw fixed voice revenue decline 15% to AUD 2.6 billion and the EBITDA margin fall to 35% from 48%. Fixed data revenue declined 0.2% to AUD 2.5 billion, owing mainly to National Broadband Network, or NBN, migration which produced lower wholesale revenue even though total retail subscribers grew by 88,000. Increased payments to NBN halved the EBITDA margin on fixed data to 16%. NBN connections grew 770,000 to 1.9 million contributing to Telstra's 51% NBN market share, excluding satellite.

Network applications and services, or NAS, has begun to deliver on the promise of strong growth. Revenue increased 8.6% to AUD 3.6 billion, driven by a 14.4% increase in cloud services revenue to AUD 428 million, along with 11% growth in industry solutions, which includes NBN commercial works, to AUD 1.4 billion. NAS EBITDA margin increased to 10% from 9%, leading to EBITDA of AUD 362 million.

Full-year free cashflow increased AUD 0.9 billion to AUD 4.9 billion, owing to lower working capital for NBN activities as well as lower spending on spectrum. Net debt/EBITDA remains comfortably within the 1.3 to 1.8 times target range, at 1.5 times. Interest cover is lower at 14.3 times, yet is still well above the 7 times comfort level.